For the last few weeks I’ve been sharing with you my thoughts on evaluating portfolio performance from several perspectives including:


  • Portfolio performance vs. the performance of individual investments (CLICK HERE).


  • Absolute vs. risk adjusted returns (CLICK HERE).



  • The impact of taxes on returns and social return on investments (CLICK HERE).


  • How the societal impact of an investment portfolio impacts its return (CLICK HERE).


In this post I will conclude this series of blog posts with a discussion of the seemingly basic, but very important, topic of using a benchmark to measure investment returns.  Benchmarks are an important tool when evaluating investment performance because they provide an objective standard to measure your portfolio performance.


Characteristics of a Better Benchmark

A benchmark can consist of a single index such as the S&P 500.  However, this approach can result in excessive tracking error (discussed below).  Therefore, in most cases it is best to construct a benchmark from a portfolio of several index-tracking exchange-traded funds (ETFs) that represent all the relevant components of the investment landscape.


A properly constructed benchmark should have the following traits:


  • Transparent — The way the benchmark is constructed should be disclosed and easily understood.


  • Investable — The components used to construct the benchmark should be publicly traded.


  • Measurable — The benchmark’s performance should be capable of being calculated on a frequent basis using publicly available data.


Selecting the Proper Benchmark

Selecting the appropriate benchmark is a critical component of evaluating investment performance.  Comparing the performance of your portfolio to an inappropriate benchmark can be misleading and lead to poor investment decisions.


For a benchmark to be appropriate, the specific ETFs included in the benchmark and their respective allocations should reflect the investment objective of the portfolio to which the benchmark is being compared.  For example, a benchmark for a portfolio that has a conservative investment objective would typically include a greater allocation to less risky and stable asset classes such as government bonds and/or cash equivalents.  By comparison, a benchmark for a portfolio that has a growth investment objective would typically include a greater allocation to more risky and volatile asset classes such as stocks and/or high-yield bonds.


Tracking Error

When using a benchmark to evaluate investment performance it is important to keep in mind that there will be times that the hypothetical returns that are calculated for the benchmark deviate significantly from the returns generated by a respective portfolio.  This concept is commonly referred to as “tracking error” (although I personally prefer “tracking divergence” because this deviation occurs in the absence of an error in the selection of a benchmark or the calculation of its performance).


Mistake-free causes for tracking divergence include:


  • Taxes — As discussed HERE, taxes can have a major impact on a portfolio’s real-world performance. Benchmarks don’t pay taxes.


  • Trading costs — Benchmarks do not incur trading costs.


  • Management fees — Benchmarks are passively managed and therefore don’t require an investment manager to implement.


  • Strategy Design — Every investment strategy will underperform at times because no strategy is perfect.


For example, a benchmark that remains constant is inherently riskier than a portfolio whose asset allocations are periodically adjusted in response to economic and market conditions.  Modern portfolio theory has demonstrated that investors demand to be, and therefore are, compensated for taking on more risk.  As a result, in time periods without major asset class corrections or when market volatility spikes during secular bull markets, portfolios that are adjusted to maintain consistency with the investors’ investment objectives should be expected to under-perform benchmarks that do not respond to changes in market risk.


You can learn more about how The Milwaukee Company uses benchmarks when managing our client portfolios by clicking HERE.


This concludes our discussion on evaluating investment performance.  Next time I will turn my attention to bear markets.  In particular I will be discussing, common causes for bear markets, how frequently they occur, how they impact performance and how to prepare for them.  I look forward to sharing these observations with you soon!


Important Disclosures:  Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.  Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™.


In addition, The Market Commentator℠ may contain links to articles or other information that are contained on a third party website.  The Milwaukee Company does not endorse or accept responsibility for the content, or the use, of the website.  The Milwaukee Company assumes no liability for any inaccuracies, errors or omissions in or from any data or other information provided on the pages.  Thank you.